Theory of

Production
DR. MIRABEL A. REYES

ECO1 BASIC MICROECONOMICS

1 S T S E M E S T E R S .Y. 2 0 2 3 - 2 0 2 4
Objectives
At the end of the lesson, the students should be able to:
1. explain what a production function is;
2. compare and contrast technical efficiency and economic efficiency;
3. cite the difference between fixed and variable inputs and show how the short
run is defined by the presence of these inputs;
4. differentiate between short-run period and long-run period;
5. calculate total output and marginal product when one additional input is
added;
Objectives

6. identify the stages of production and explain the significance of each stage;
7. explain how the law of Diminishing returns affects production and hiring
decisions;
8. apply the optimum input usage rule in optimizing resource use;
What is Production?

It is any economic activity which combines the four factors of production to form
an output that will give direct satisfaction to consumers.
It is an act of combining factors of production by firms or institutions in order to
produce outputs of goods and services.
It is a process of converting inputs to outputs.
It refers to the transformation of inputs to marketable outputs.
Inputs
These are commodities or services that are used to used to produce goods and
services.
Factors of Production:
1. Land - natural resources; represents the gift of nature to our production
process.
2. Labor - mental and physical ability used in the production of goods and
services
3. Capital - goods that are used in the production of other goods and services
4. Entrepreneurial abilities
Outputs

These are various useful goods and services that result from the production
process and are either consumed or employed in further production.

a. Final Goods – goods and services that are ultimately consumed

b. Intermediate Goods – goods that are used to produce other goods

Technology
It refers to a body of knowledge applied to how goods are produced
It also refers to the production process employed by firms in creating goods and
services

2 broad categories

a. Labor Intensive Technology

b. Capital Intensive Technology
 Technical Efficiency and Economic Efficiency

When a minimum quantity of input is used to produce a maximum quantity of output,

the production process is said to be technically efficient. In a technically efficient
production process, inputs are utilized in such a way that avoid wastage and idleness.
Economic efficiency occurs when a firm is able to produce goods and services at the
least cost.
Exercise L5a
Supposed that a firm is given
production techniques 1, 2, and 3. Q = 100 Q = 150 Q = 200
Which technique is technically and
economically efficient for producing
K L K L K L
100 units, 150 units and 200 units of Tech 1 2 8 3 10 4 12
outputs? Assume that the cost of
capital (K) is Php 100 and the cost of
Tech 2 3 5 4 7 5 8
labor (L) is Php 50. Tech 3 4 2 5 4 6 5
Solution

Q = 100 Q = 150 Q = 200

K L Total K L Total K L Total
Tech 1 200 400 600 300 500 800 400 600 1000
Tech 2 300 250 550 400 350 750 500 400 900
Tech 3 400 100 500 500 200 700 600 250 850

Cost per Unit Produce

Q =100 Q = 150 Q = 200
Tech 1 6.00 5.33 5.00
Tech 2 5.50 5.00 4.50
Tech 3 5.00 4.67 4.25
Fixed and Variable Input

A Fixed Input is an input whose quantity remains the same despite changes
in output. It can also be viewed as any resource, the quantity of which cannot
readily be changed when market conditions indicate that a change in output is
desirable.
A Variable Input is an input whose quantity changes as volume of output
changes. It can also be viewed as any economic resource the quantity of which
can be easily changed in reaction to change in output level.
Long-run Period and Short-run Period
A Long-run Period is a period long enough to allow a firm to adjust all types of
input in order to increase or decrease its volume of output. It begins as soon as
the Law of Diminishing Returns takes its toll in the short-run operation of the
firm.

It can also be referred to a period of time so long that all inputs are considered
variable, also known as the Planning Horizon.
A Short-run Period allows the firm to adjust only its variable inputs.
It can also be referred to a period of time so short that there is at least one fixed
input therefore, changes in the output level must be accomplished exclusively
by changes in the use of variable inputs.
Exercise L5b
DETERMINE IF DECISION TO BE MADE BY THE
IDENTIFY IF FIXED INPUT OR VARIABLE
FIRM IS FOR SHORT-RUN OR LONG-RUN
INPUT PERIOD
1. Factory Space 1. SM decides to stay open 24 hours rather
than 12 hours.
2. Electric Consumption
2. Gardenia builds another production
3. Ceramic pattern or mold for a
facility in Cagayan de Oro
particular design
3. Cebu Pacific increases flight schedules to
4. Fuel to run the machine
accommodate more passengers.
5. Managers
4. BPO company hires more call agents for
6. Heavy equipment its graveyard shift.
Production Function

A Production Function is commonly expressed as an equation or table that shows the

maximum amount of output a firm can produce with each set of inputs.

It can also be defined as functional relationship between quantities of inputs used in

production and outputs to be produced. In general, the quantity of inputs used in the
production process runs directly proportional to the quantity of output.

It specifies the maximum output that can be produced with a given quantity of inputs
and given the existing technology of the firm.
Example

OT-shirt = f ( Fabrics, Sewing Machine, Sewer, Thread, Buttons,

space or factory, electricity, etc.)
The Law of Diminishing Marginal Returns
The Law of Diminishing Marginal Returns states that the additional product attributable to the use of
an extra variable input will diminish at a certain point as the quantity of that variable input is
continuously raised while the quantity of fixed inputs remain the same.
To put it in another way, that the Law of Diminishing Returns holds that we will get less and less
extra output when we add additional doses of an input while holding other inputs fixed.
The constraint of a fixed plant size or equipment leads to a diminishing trend in the Marginal Product
that causes an eventual decline in the level of output.
For instance, increasing the number of workers in a construction site without increasing the tools
needed by the workers will yield decreasing additions or even none at all to total output. Confusion,
conflict and even deterioration of fixed input may result from this constraint.
Marginal Product
Marginal Product is the additional output that is produced as an extra unit of variable
input is employed.
Marginal Product = Change in Total Product/Change in Quantity of Input used
Marginal Product = Total Productnew - Total Productold
Inputnew - Input old
MP = TPnew - TPold
Inew - Iold
Average Product

Average Product is the output per unit of variable input which is generally viewed as
a measure of productivity of the variable input.
Average Product = Total Product
Total Quantity of Input used
Exercise L5b and L5c
TOTAL PRODUCT, MARGINAL PRODUCT TOTAL PRODUCT, MARGINAL PRODUCT
AND AVERAGE PRODUCT AND AVERAGE PRODUCT

Labor Units Total Marginal Average

(Input used) Product Product Product
Labor Units Total Marginal Average
0 0 0 0 (Input used) Product Product Product
1 40
2 110 1 40
3 200
4 320 2 48
5 450
6 550
3 138
7 620 4 44
8 620
9 600 5 24
Stages of Production
1. Increasing or Positive Return Labor Units Total Marginal
Stages of Production
(Input used) Product Product
2. Diminishing or Decreasing Return
0 0 0 -
3. Negative Return 1 40 40 Increasing Returns
All these stages take place during the short-run or the 2 110 70 Increasing Returns
operating period of the firm. The proper identification 3 200 90 Increasing Returns
of these stages is crucial in the hiring decision of the 4 320 120 Increasing Returns
firm. 5 450 130 Increasing Returns
In the short-run period, a profit seeking firm will 6 550 100 Diminishing Returns
continue hiring extra workers at the stage of increasing 7 620 70 Diminishing Returns
returns, be critical in hiring at the stage of diminishing 8 620 0 Diminishing Returns
returns and never hire additional workers at the stage
9 600 -20 Neagtive Returns
of negative returns
Increasing or Positive Returns

This happens when the Marginal Product of an additional worker EXCEED the
Marginal Product of the previous worker.

During the stage of increasing or positive returns, the additional outputs (Marginal
Product) of each additional worker will rise due to increased productivity brought
about by division of labor, teamwork and specialization.
Diminishing or Decreasing Returns
This occurs when the Marginal Product of an additional worker is LESS than the
Marginal Product of the previous worker hired to do the same task

The additional product of every worker will diminish as the firm continues to hire
more workers without expanding its plant size or increasing the types of
equipment that the additional worker will handle. There is decline in
productivity, as some workers might be underemployed because they might just
be standing around waiting for space or machine to be available.
Exercise L5d
Quantity of Total Marginal
Stages of Production
Labor Used Product Product
The following data describe a short- 0 0 - -
run production function for a 10 50
garment company that hires workers 20 150
to sew read-to-wear dresses. 30 300
40 550
Complete the table and identify the
50 700
stages of production 60 800
70 850
80 850
90 800
Optimum Input Hiring
The optimum hiring rule dictates that a firm should continue hiring additional units of
variable (labor) input as long as the extra revenue generated from the sale of the
additional output (Marginal Revenue Product) exceeds the cost of hiring that unit of
input (Marginal Resource Cost).
Marginal Revenue Product (MRP) is the additional revenue generated by the sale of
the Marginal Product of the extra input.
Marginal Resource Cost (MRC) is the extra cost of hiring the additional input.
Formula

MRP = Price of the product x Marginal Product

or
MRP = Change in Total Product/ Change in the Quantity of Labor
MRC = Cost of the Variable Input or Wage Rate per person
or
MRC = Change in Total Cost of Labor/ Change in Quantity of Labor
A profit maximizing firm should continue hiring extra workers until the last
worker’s MRP = MRC.
Exercise L5e

GIVEN INFORMATION TABLE TO BE FILLED UP

Quantity MRC or
TP MP MRP Comparison
Assume that at each labor unit is of Labor Wage
1 40 40
paid Php 1000 and that the product
2 110 70
is sold at Php 10 per piece, Compute 3 200 90
for the MRP and MRC and indicate 4 320 120
the comparison 5 450 130
6 550 100
7 620 70
8 620 0
9 600 -20
Solution
Quantity MRC or
TP MP MRP Comparison
of Labor Wage
1 40 40 400 1000 MRP<MRC
2 110 70 700 1000 MRP<MRC
3 200 90 900 1000 MRP<MRC
4 320 120 1200 1000 MRP>MRC
5 450 130 1300 1000 MRP>MRC
6 550 100 1000 1000 MRP=MRC
7 620 70 700 1000 MRP<MRC
8 620 0 0 1000 MRP<MRC
9 600 -20 -200 1000 MRP<MRC

The firm should hire 6 workers, with 550 units of output produced.
Optimum Hiring of 2 Variable Inputs
For multiple input usage, like labor and capital, a profit maximizing firm will employ the
input combination at which:
Wage = Marginal Product of labor
Cost of Capital Marginal Product of Capital
At this input stage, the Marginal Product per dollar or peso paid on each input is the
same for all.
Marginal Product of Labor = Marginal Product of Capital
Wage Cost of Capital
Optimum Hiring of 2 Variable Inputs
When the Marginal Product per dollar or peso spent on Labor exceed the Marginal Product per
dollar or peso spent on Capital, the firm can reduce cost by increasing labor usage while
decreasing capital to keep its output constant. As more labor is used, the Marginal Product of
Labor declines due to the Law of Diminishing Marginal Returns. On the other hand, as less capital
is used, the Marginal Product of Capital rises.

As the firm substitute more and more Labor for capital, the Marginal Rate of Technical
Substitution falls until equilibrium is reached or optimum resource allocation is achieved.

Marginal Rate of Technical Substitution is the rate at which a firm may substitute an extra amount
of Labor with an extra amount of Capital without affecting the quantity of the output.

A firm may re-arrange input combinations to enable it to increase total output without increasing
total cost.
Example

SCENARIO SOLUTION
A small scale weaving factory in Benguet, Marginal Product of Labor = 10
weaves cloth by hand even though a
Wage or Price of Labor = 250
weaving machine exists. On the average, a
weaver can produce 10 yards daily and is Marginal Product of Capital = 20
paid Php250 per day. The company believes Price of Capital = 1000
that the purchase of one machine will 10 = 20
increase output by 20 yards. The cost of
250 1000
operating the machine is Php1000 per day.
Can the firm reduce the cost of weaving 0.04 > 0.02
540 units per day by purchasing a machine The firm should hire more workers instead of
and using less labor? Why and why not? purchasing a machine.
References:
Books:
1. Cruz, Milagros A., (n.d.) A Study Guide: Microeconomics, Self publication.
2. Cruz, Milagros A. (2017) Business Economics, Anvil Publishing, Inc.
Mandaluyong City, Philippines. ISBN 978-971-27-3325-3
Images
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function-ppt-in-economics-6-320.jpg?cb=1665821233
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References
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References
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 Isoquant and
Isocost
DR. MIRABEL A. REYES

ECO1 BASIC MICROECONOMICS

1 S T S E M E S T E R S .Y. 2 0 2 3 - 2 0 2 4
Objectives
At the end of the lesson, the students should be able to:
1. draw a typical production isoquant on a graph and explain its basic assumptions;
2. explain why isoquants must be downward sloping;
3. discuss the properties of an isoquant;
4. construct an isocost curve for a given level of budget on inputs;
5. apply the input usage optimization rule to find the optimal input combination.
Production Isoquant

An isoquant schedule or curve shows the different combinations of inputs that

correspond to the same level of output.
Note that the concept of the indifference curve is similar to that of the isoquant
curve
Example
A two-input production function is Isoquant Curve
generally illustrated in an isoquant schedule
or curve. 10

Isoquant Table 8

Labor (L) Capital (K) Capital 6

2 9 4

3 4 2

6 1 0 2 4 6 8

Labor
ISOQUANT ISOQUANT MAP
Properties of Isoquant Curves
1. Downward sloping and convex to the point of origin
The slope of the isoquant curve reflects the degree of substitutability of inputs and an inverse
relationship between inputs used in producing the same level of output. This is because the utilization of
one less input is regained by utilizing more of the other input in order to keep output constant. The
equality between the units of input regained and foregone holds the level of output constant. The
downward sloping isoquant curve and it convexity illustrate the principle of diminishing returns.

2. Non-intersecting

The set of isoquant curves in an isoquant map should never intersect. This is because changing the level
of both inputs at every combination along the isoquant curve leads to higher isoquant and output level.
The further the isoquant curve from the point of origin, the more units of each input are utilized and the
higher the output produced.
Isocost Line
An Isocost Line shows the different combination of inputs a producer can afford
in producing a specific quantity of goods or service.
It is similar to the Budget Line.
1. Both indicate some combinations (of goods or inputs) that an individual
(consumer or producer) may afford.
2. Both hold a certain factor constant namely utility for budget line and quantity
of output for the isocost line.
3. Both are negatively sloped suggesting a process of substitution takes place as
one moves from one point to another along the line.
Isocost Line

To construct an isocost line, an X and Y Y intercept = Maximum amount of K (Capital)

intercept must be determined. X and Y
= Budget
represent any type of input that may be
employed in the production process. The X Price of K
and Y intercepts of the isocost line are
X intercept = Maximum amount of L (Labor)
derived by determining the maximum
amount of labor and capital that may be = Budget
purchased with the budget, given their
respective cost Price of L
Sample Problem
With a budget of Php 120,000 wherein the 10

cost of using each unit of capital is Php 8

15,000 and the cost of hiring each unit of
labor is Php 10,000, the isocost line is drawn Capital 6
connecting the X and Y intercept.
4
Y Intercept = 120,000 = 8 units of K
2
15,000
0
X Intercept = 120,000 = 12 units of L 3 6 9 12 15

10,000 Labor
Shifting of the Isocost Line
10
1. Changes in the cost of an input
8
Suppose the price of labor increase from Php
10,000 to Php 15,000. Capital 6
The isocost line while remaining anchored in
4
its original position on the vertical axis will
pivot to the left (inward) 2

New X intercept = 120,000 = 8 units of L 0

3 6 9 12 15
15,000
Labor
Y intercept remains at 8 units of K
Shifting of the Isocost Line
2.Changes in the Production Budget 10

A decrease in production budget leads to a 8

lower Isocost Line. The isocost line shifts to
the left when input prices remain the same Capital 6
but budget falls. Suppose the budget falls
from Php 120,000 to Php 80,000 4
Y intercept = 80,000 = 5.33 units of K
2
15,000
0 2 4 6 8 10 12
X intercept = 80,000 = 8 units of L

10,000 Labor
Exercise 5LB1
Supposed that a producer is faced with an input combinations that yields 500 units. Assume that the
capital and labor cost Php 1,000 each and production budget is Php 4,000 Complete the table below
and plot the isoquant curve and isocost line in a graph. Determine the input combination that
corresponds to the least cost

Isoquant and Isocost Table

K L Cost (K) Cost (L) Total
Isocost Line
1 4 0 4
2 2
4 1 4 0
The Optimum Input Combination

The point of tangency between an isoquant curve and an isocost line represents the input that is
both technically and economically efficient.

Any combinations at the isoquant curve below the isocost line and the combinations at either points
of intersection with isocost lines are affordable. It should be noted that the input combinations at
these alternative points correspond to the same budget and output levels.
References:
Books:
1. Cruz, Milagros A., (n.d.) A Study Guide: Microeconomics, Self publication.
2. Cruz, Milagros A. (2017) Business Economics, Anvil Publishing, Inc.
Mandaluyong City, Philippines. ISBN 978-971-27-3325-3
Images
https://www.investopedia.com/thmb/9sGyfrCNq3yRbYNH18_HmXentmA=/750x
0/filters:no_upscale():max_bytes(150000):strip_icc():format(webp)/isoquantcur
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filters:no_upscale():max_bytes(150000):strip_icc():format(webp)/marginal_rate_
of_substitution_final2-893aa48189714fcb97dadb6f97b03948.png
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 Cost of
Production
DR. MIRABEL A. REYES

ECO1 BASIC MICROECONOMICS

1 S T S E M E S T E R S .Y. 2 0 2 3 - 2 0 2 4
Objectives
At the end of the lesson, the students should be able to:
1. calculate the explicit cost and implicit cost in producing goods or services;
2. estimate the total cost, average total cost, average fixed cost, average variable
cost and marginal cost;
3. explain the behavior of each cost curve and its relationship to the others;
4. estimate cost using the graph;
5. differentiate between total accounting and economic cost;
Objectives

6. define profit and illustrate how economic profits differ from accounting
profits;
7. explain how short-run costs affect a firm’s production decisions;
8. identify the relationship of price, revenue and profit;
9. use the TC-TR/ MC-MR approaches in determining the profit-maximizing
output level of a firm;
10. create a small scale business plan and calculate its total cost of production.
COSTS

Cost is the value of inputs that were utilized in the

production process. It is also used as a basis in deciding
whether one should proceed or stay out of business.
 IMPLICIT COST

An Implicit Cost involves no obvious cash outlay. It is the value of the next best use of
the unremunerated input
How much cost should a entrepreneur include in his total cost computation?
2 Factors to consider:
1. Market price of self-owned input.
2. Opportunity cost of the self-owned input
 EXPLICIT COST

Explicit Costs are costs that involve actual expenditure or actual purchases. These
costs are readily identified. Accounting records always reflects this type of cost.
Economic Cost = Implicit Cost + Explicit Cost
Accounting Cost = Explicit Cost
An entrepreneur must include all explicit and implicit costs to estimate his profit
correctly and make rational business decision
Exercises
EXERCISE L6A1 EXERCISE L6A2
Determine whether each of the following is Ken quit his job as an architect with a salary of Php
400,000 per annum to start his own firm in a unit or
an EXPLICIT COST or IMPLICIT COST:
space that he owns in the business district and rented
1. payment for hiring call center agents out at PHP 200,000 per year until the lease expired.
He estimated that the following expenses in his 1st
2. wages that one could have earned had year of operation: utilities, Php 150,000; computers
and other fixtures Php 300,000 ( 5 year use);
he not put up his own business
employees salaries Php 900,000; representation
expenses, Php 50,000; office supplies Php 40,000. Ken
3. interest of a deposit which was used as a
intends to withdraw his bank savings of Php 300,000
capital in business that yields 2% interest per annum to defray initial
expenses. Total Revenue during the year is estimated
4. payment of raw materials that were at Php 2,000,000. Compute his explicit costs and
ordered from a supplier implicit costs.
 PROFITS
Profit is the reward for the entrepreneurial talent of a businessman who combine all resources to
create a marketable good or service. It is estimated by deducting the cost of production from the
revenue realized from selling the output at specific price.

Total Revenue = Price x Quantity of Goods Sold

Profit (Loss) = Total Revenue (TR) - Total Cost (TC)

If TR > TC , you have a Profit, if TR < TC, you have a Loss

Accounting Profit = Total Revenue - Explicit Cost

Economic Profit = Total Revenue - (Explicit Cost + Implicit Cost)

Normal Profit = Zero Economic Profit (Break-even)

 Exercise L6A3
Jess is earning Php 30,000 a month as a teacher in a private school. He is contemplating of quitting his
job to start his own business selling aquarium fish. He believes his entrepreneurial talent is worth Php
10,000 a month which had foregone as a teacher. He is planning to use PHP 200,000 of his savings,
which is currently providing him 2% per annum interest, for his 1st year of operation. Utility expenses
are estimated at Php 12,000 a month and will pay a helper Php 8,000 a month. He figures that he can
save Php 7,000 monthly rental if he converts his garage into a mini shop. Feeds are estimated at Php
1,500 a month. The aquaria, submersible pumps, lighting and other gadgets will cost Php 100,000 on
the average but are expected to last for 5 years.

In his 1st year of business, he is optimistic that he will be able to sell 15,000 fish at an average price of
Php 75 each. The average cost of fish is estimated to be Php 30 per piece. Generally 20 fish die due to
disease every month.
Exercise L6A3 Continuation
Compute for the following:
A. Explicit Costs and Implicit Costs during the year
B. Accounting Cost and Economic Cost of the business
C. Accounting Profit and Economic Profit for the 1st year of business operation
D. Should Jess put up his own business? Why? Why not?
FIXED COST

A Fixed Cost remains the same at any level of output. Or put in another way,
fixed cost remains constant regardless of the level of output.
Examples:
Rental Payment Cost of heavy equipment
Salaries of Managers Advertising Expenses
Interest Payments Insurance Payments
Salaries of Regular workers
 VARIABLE COST

Variable Cost varies in direct proportion to output.

Examples:
Salaries of part-time workers Cost of Raw Materials
Electricity and Water Cost of Tools.
TOTAL COST

Total Cost is equal to the Total Fixed Cost at zero output.

Total Cost = Total Fixed Cost + Total Variable Cost

Total Variable Cost = Total Cost - Total Fixed Cost
Total Fixed Cost = Total Cost - Total Variable Cost
CHARACTERISTICS OF THE COST CURVES

Total Fixed Cost is constant and plotted in the graph as a horizontal line.

Total Variable Cost increases as output increases hence it slopes upward.

Total Cost follows the trend of the variable cost.

The gap between Total Cost (TC) and Total Variable Cost (TVC) is the Total Fixed Cost (TFC).

At the higher of output, TVC increases at an increasing rate due to the principle of diminishing
returns. The Marginal Product (MP) begins to decline at the stage of diminishing marginal returns
and the continuous use of variable inputs contributes to the Total Variable Cost and Total Cost.
 PER UNIT COST
Average Total Cost = Total Cost = Average Fixed Cost + Average Variable Cost
Quantity
Average Fixed Cost = Total Fixed Cost = Average Total Cost – Average Variable Cost
Quantity
Average Variable Cost = Total Variable Cost = Average Total Cost – Average Fixed Cost
Quantity
Compared the Selling Price, the Average Total Cost will determine the profit per unit of
output. It is useful in haggling or price negotiation and is used in short-run decisions
PER UNIT COST
Marginal Cost is the additional cost of producing an extra unit of output.
Marginal Cost = Change in Total Cost = dTC
Change in Output dQ
Marginal Cost = Change in Total Variable Cost = dTVC
Change in output dQ
Marginal Cost at the first unit of output is equal to the Total Fixed Cost at zero output.
The Marginal Cost Curve above the MC = AVC output level also serves as the firm’s
Supply Curve.
Exercise L6A4
Complete the Cost Table below. Show your solutions

Q TFC TVC TC AVC ATC MC

0 2200 0 0.00 0.00 0.00
14 400 28.57
36 22.22
66 3400 51.52
92 1600 41.30 15.38
110 2000 4200 18.18 38.18 22.22
120 2400 4600 20.00 38.33 40.00
Exercise L6A5
Vanessa runs a small business. Complete her cost table below.

Q TFC TVC TC AFC AVC ATC MC

0 1000
1 1400
2 1600
3 1700
4 1900
5 2120
BEHAVIOR OF ATC, AFC, AVC, and MC CURVES
Average Fixed Cost (AFC) is downward sloping.
Average Total Cost is high at a lower output, but as the firm continues to produce more output, the
Fixed Cost is distributed over a larger output thereby reducing the average cost per unit of output.
Average Fixed Cost slopes downward as Fixed Cost is spread over a larger output.
Average Total Cost (ATC) and Average Variable Cost (AVC) are both U-shape.
ATC follows the shape of AVC. The vertical gap between ATC and AVC is the AFC. Average Total Cost
rises at higher output even if Average Fixed Cost is declining. This is because the increase in variable
costs as more and more quantities are produced pushes Total Cost upward. Marginal Cost (MC)
intersect ATC and AVC at their minimum points.
Marginal Cost (MC) Curve is generally J-shaped.
.
COST and PRODUCT CURVES
Product Curves ( Marginal Product and Average Product) are the mirror image of the
Cost Curves ( Marginal Cost and Average Variable Cost).
This is due to increased productivity brought about by teamwork, division of labor
and specialization that takes place when hiring more variable input of labor at the
stage of increasing or positive returns. When the firm approaches the stage of
diminishing returns, its Marginal Product reaches its peak and falls thereafter. Thus,
Marginal Cost of the extra output stop falling. At the stage of increasing returns, we
have the maximum Marginal Product (where Average Product = Marginal
Product),and we have the Marginal Cost is at its minimum ( Average Variable Cost =
Marginal Cost).
COST and PRODUCT CURVES

At the stage of diminishing and negative returns, Marginal Product continues to

fall while Marginal Cost increases. Average Variable Cost rises due to the Law of
Diminishing Returns. At the stage of negative returns, Average Product is greater
than Marginal Product ( AP > MP) while Average Variable Cost is less than the
Marginal Cost ( AVC < MC). It is also interesting to note that, at the intersection of
Marginal Product and Average Product ( MP = AP), Marginal Cost is at its minimum
point ( MC = AVC ).
OTHER COST CONCEPTS
Sunk Cost is a fixed cost. It is past expenditure that cannot be recovered or change by any
decision in the future. These cost is irrelevant in deciding how much to produce in the short run
or in determining whether or not to stay in business.

Examples : Start-up Cost, Advertising Expense, Staff Training Costs, Research & Development Cost

Incremental Cost is the additional cost a firm incur if it takes on a product line or service other
than what is already engaged in. It involves the additional cost of pursuing another course of
action along with existing business.

Example: a hair salon that expands to include spa services

Long-run Average Cost curve consists of a series of short-run cost curves based on the selection
of the best scale of production for each level of output.
OTHER COST CONCEPTS
Economies of Scale occur when the long-run average cost falls as output
increases
Examples: Manila Metro Rail Transit, Light Rail Transit, Philippine National
Railway systems
Diseconomies of Scale occur when long-run average cost rises as output
increases.
Example: Pharmaceutical Industry
References:
Books:
1. Cruz, Milagros A., (n.d.) A Study Guide: Microeconomics, Self publication.
2. Cruz, Milagros A. (2017) Business Economics, Anvil Publishing, Inc.
Mandaluyong City, Philippines. ISBN 978-971-27-3325-3
Images
https://marketbusinessnews.com/wp-content/uploads/2015/07/economic-
cost.jpg
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ters:no_upscale():max_bytes(150000):strip_icc()/Term-Definitions_Production-
Costs__V1_CT-3-blue-97c7a24b6e2d4ab48d076dab29faf6a3.jpg
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x0/filters:no_upscale():max_bytes(150000):strip_icc()/Implicitcost-blue-
df62d5d36fdd4f09a544609863ec6234.jpg
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lters:no_upscale():max_bytes(150000):strip_icc()/Explicitcost_final-
34ef4af492b04f6fa474df55ee234dc1.png
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explicit-costs-1.png
https://www.wallstreetmojo.com/wp-content/uploads/2018/06/Accounting-
Profit-vs-Economic-Profit-1.jpg
References
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588e5980266a4a308dad1a9e2356a94b.jpg
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tbn0.gstatic.com/images?q=tbn:ANd9GcS8MfQaCwESRGNxHQTiwTtGgU0_5Eh2
PfhDww&usqp=CAU
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=CAU
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_upscale():max_bytes(150000):strip_icc()/TermDefinitions_Fixedcost-
262ceb69354340e7a8bbd1c05adb3771.jpg
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0Ld_Ljo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/variablecost_definitio
n_0718-1213aa036d30435499a3af3030fc6b72.jpg
References
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card-260nw-2121450113.jpg
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References
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/images/pic154.gif
 Profit
Maximization
DR. MIRABEL A. REYES

ECO1 BASIC MICROECONOMICS

1 S T S E M E S T E R S .Y. 2 0 2 3 - 2 0 2 4
Objectives
At the end of the lesson, the students should be able to:
1. explain how a competitive firm determines its profit-maximizing level of
output given the demand and cost data;
2. explain how a less than purely competitive firm determines its profit –
maximizing level of output and the price that will be set given the demand and
cost data;
3. identify a competitive firm’s short-run supply curve;
4. apply c marginal analysis to determine the profit-maximizing or loss-
minimizing level of output;
Objectives
5. Explain why a firm must continue operating at the loss-minimizing level of
output;
6. Explain why a firm should shut down in the short-run if market price falls
below the average variable cost;
7. Estimate costs, revenue and profit using the graph;
8. Apply the break even formula to determine a firm’s break-even output;
9. Cite the importance of calculating break-even quantity;
10. Create a small scale business plan and estimate its break-even quantity.
Total Revenue – Total Cost Approach
The Total Revenue comprises the total proceeds one receives from selling a
particular quantity of goods at a specific price.
TR = P x Q
As long as revenue exceeds cost, the firm realizes profit. Total Profit is maximized
when the firm produces output at a level at which the gap between Total
Revenue and Total Cost is at its widest.
Break-even Point

The Break-even Point is found at the output level where Total Revenue and Total Cost are equal.

The firm receives zero economic profit.

Q Price TR TVC TC Profit

0 150 0 0 100 -100
1 150 150 100 200 -50
2 150 300 180 280 20
3 150 450 300 400 50
4 150 600 450 550 50
5 150 750 620 720 30
6 150 900 800 900 0
Marginal Revenue and Marginal Cost Approaches
Marginal Revenue is the additional revenue a firm gets out of selling one extra output.

MR = Change in TR = (TR2 – TR1)

Change in Q (Q2 – Q1)

Marginal Cost is the additional cost of producing an extra unit of output.

MC = Change in TC = (TC2 – TC1)

Change in Q (Q2 – Q1)

Example : Profit Maximizing Case
Q Price TVC TC AVC ATC P = AR = MR MC Profit Comparison Course of Action
0 150 0 100 0 0 - - -100 - -
1 150 100 200 100.00 200.00 150 100 -50 MR > MC Expand Output
2 150 180 280 90.00 140.00 150 80 20 MR > MC Expand Output
3 150 300 400 100.00 133.33 150 120 50 MR > MC Expand Output
4 150 450 550 112.50 137.50 150 150 50 MR = MC Profit is Maximized
5 150 620 720 124.00 144.00 150 170 30 MR < MC Contract Output
6 150 800 900 133.33 150.00 150 180 0 MR < MC Contract Output
Notation:
As long as MR > MC , to realize more profit, a firm will have to continue to expand output.

A firm will maximize profit at the output level where MR = MC, hence the firm stops adding more
output once this is achieved.

If MR < MC, any additional output will reduce potential profit.

At times, a firm may find two MR and MC intersections. In this case, the first intersection, which
occurs at the stage of increasing returns has to be ignored. The second intersection is more
significant.
Loss Minimization

A firm respond to changes in the market. In a competitive market where sellers are
free to enter the market, a higher supply will lead to a price reduction. With a
lower price, profit may be eliminated or reduced. Thus, a firm must adjust its
output to minimize loss.
To minimize losses in the short-run, the firm must produce at the output level
where MR = MC.
Example : Loss- Minimizing Case
Supposed Price decrease from Php 150 to Php 120

Q Price= AR TVC TC AVC ATC P = AR = MR MC Profit Comparison Course of Action

0 120 0 100 0 0 - - -100.00 - -
1 120 100 200 100.00 200.00 120 100 -80.00 MR > MC Expand Output
2 120 180 280 90.00 140.00 120 80 -20.00 MR > MC Expand Output
3 120 300 400 100.00 133.33 120 120 -13.33 MR = MC Loss is Minimized
4 120 450 550 112.50 137.50 120 150 -17.50 MR < MC Contact Output
5 120 620 720 124.00 144.00 120 170 -24.00 MR < MC Contact Output
6 120 800 900 133.33 150.00 120 180 -30.00 MR < MC Contact Output
Notation:
To minimize losses in the short run, the firm must produce at the output level where MR = MC.

Since the price of the product is still enough to cover its Average Variable Cost, that is, all
utilities, raw materials and other variable costs, the firm may continue producing despite the
loss. The firm should however, attempt to reduce Total Cost by adopting more efficient
production method and reducing wastage in the company.

The introduction of a more cost-efficient technology, substitution of cheaper inputs,

modernization of production facilities or more aggressive marketing strategy will help redeem
profit.
Shut-down Condition
The firm must shut down in the short-run if Price is not enough to cover the
Average Variable Cost ( P < AVC).
Supposed Price further falls from Php 120 to Php 80.
Q Price= AR TVC TC AVC ATC P = AR = MR MC Profit Comparison Course of Action
0 80 0 100 0 0 - - -100.00 - -
1 80 100 200 100.00 200.00 80 100 -120.00 MR < MC Stop operating
2 80 180 280 90.00 140.00 80 80 -60.00 MR = MC Stop operating
3 80 300 400 100.00 133.33 80 120 -53.33 MR < MC Stop operating
4 80 450 550 112.50 137.50 80 150 -57.50 MR < MC Stop operating
5 80 620 720 124.00 144.00 80 170 -64.00 MR < MC Stop operating
6 80 800 900 133.33 150.00 80 180 -70.00 MR < MC Stop operating
Summary
A firm refers to MR and MC level to determine its optimum output level
MR = MC
A firm refers to AR and ATC to calculate profit or loss
If AR > ATC, profit is realized
If AR < ATC, loss is incurred
A firm refers to P and AVC to decide whether to continue operating or not
If P > AVC, continue producing
If P < AVC, shut down
Notation

A firm achieves productive efficiency when it produces at P = ATC level of output. This implies that
at the current level of output, the firm is using a technologically and economically efficient input
combination.

A firm achieves allocative efficiency when it produces at P = MC level of output. The equality
between P and MC suggests that the firm is allocating resources for the right product in the right
amount according to the needs of society.
Exercises

EXERCISE L5D1 EXERCISE L5D2

You have been hired as a consultant by a firm to
determine whether it should temporarily close Given The following firm’s data:
shop or continue its operation despite some
losses. Currently the firm has 20 workers who Fixed Cost: Php5,000,000
are paid Php400 each. The firm produces a daily
output of 500 units and sells them at Php30. Variable Cost: Php6,000,000
The cost of other variable inputs is Php2000 per
day. The firm’s total cost exceed its total Total Revenue: Php7,000,000
revenue. The marginal cost of the last unit is
Php30. Should the firm continue to operate at a Will the firm still operate or shut
loss? Justify your decision by showing all your down? Why ? Why not?
computation
Exercises

EXERCISE L5D3 EXERCISE L5D4

Indicate whether the firm should produce or shut
down in the short-run.
What does a firm do in the short run if its
a. TR > TC at all output level
Fixed Costs are Php10,000,000 its Variable
Costs are Php9,000,000 and its Total b. TR < TVC at the current output level
Revenue is Php8,000,000? Will it operate or
c. TR > TFC at all output levels
shut-down? Why or Why not?
d. MR < MC at the current output level
e. P > ATC at all output level
f. P < AVC at the current output level
e. P < ATC at all output level
Short-run Supply Curve of the Firm
A firm’s short-run supply schedule may be derived once the optimum quantities are determined
at each price level. The firm’s supply curve consists of the quantities supplied above the point
P = MC = AVC.

Given:
Q AVC ATC P = MR P = MR P = MR P = MR MC Firm's Supply Curve
0 0 0 - - - - -
1 100.00 200.00 170 150 120 80 100
Price Quantity
2 90.00 140.00 170 150 120 80 80 170 5
3 100.00 133.33 170 150 120 80 120 150 4
4 112.50 137.50 170 150 120 80 150
5 124.00 144.00 170 150 120 80 170
120 3
6 133.33 150.00 170 150 120 80 180 80 0
Break-Even Quantity
A profit seeking enterprise will always
determine how high they are from the
break even point or margin of safety. This
serves as a valuable guide to how much the BEQ = Fixed Cost
firm must sell in order to make a profit from Price per unit – Variable Cost per unit
its operation. The firm should be able to
make the necessary adjustment to its
selling price, fixed or variable expenses BEQ = Fixed Cost + Desired Profit
should it find the break-even point
unsatisfactory. Unit Selling Price – Unit Variable Cost
Sample Problem
Supposed that Judy’s Bakeshop sells large crunchy chocolate bit cookies at Php125 per piece and
the following are the cost data:
Fixed Cost per Month Variable Cost per Cookie
Rent Php8000 Chocolate Php30
Utilities Php3000 Special Dough Php50
Labor Php15000
Using the data, the monthly break-even quantity of cookies is:
BEQ = 26,000 = 26,000 = 577.78 or 578 units
125 - 80 45
Exercise L5D5
1. Using the data of Judy’s Bakeshop, suppose that the firm wants to earn a profit of Php5,000
per month. How much quantity must it sell?

2. Suppose that Judy’s Bakeshop is confident it can sell 600 cookies per month but wants to earn
Php5,000 for it, how much must it charge for a cookie?

3. Suppose that the cookie dough cost increases fromPhp50 to Php70 while other costs remain
the same. How many cookies need to be sold to break-even assuming that the price remains at
Php125 per piece and the desired profit remains at Php5,000 per month?

4. What price must it charge per cookie if it believes it can sell 600 cookies per month. Use the
new unit variable cost.
Profit Maximization (Mathematical Approach)
Given the firm’s total cost function, TC = 2,000 + Q and its demand function , P = 50 - 0.1Q
determine the profit-maximizing or loss minimizing output. Calculate its profit or loss.

Steps:

1. Derive MR and MC function from TR and TC

2. Get the derivative of TC

TC = 2,000 + Q

MC = dTC/dQ

MC = 1
Profit Maximization (Mathematical Approach)
3. Get the derivative of TR 5. Solve for TR and TC
TR = P x Q TR = P x Q
TR = (50 - 0.1Q)Q
= 25.50 (245)
= 50Q – 0.1Q2
= Php6,247.50
MR = dTR/dQ
TC = 2,000 + Q
MR = 50 – 0.2Q
= 2,000 + 245
4. Equate MR to MC
50 – 0.2Q = 1 = Php2,245

49 = 0.2Q 6. Compute for Profit

245 = Q TR - TC
P = 50 – 0.1 (245) = Php25.50 Php6,247.50 - Php2,245 = Php4,002.50
Exercise L5D6
Find the 1st Derivative of each of the following functions:
1. TC = 5000 – 5Q + 0.2Q2
2. Q = -77
3. P = 5Q + 20Q2 – Q
4. TC = 10Q7
Exercise L5D7

Find the profit maximizing output if demand for the product is given as
Qd = 150,000- 10,000P and the Total Cost is TC = 20,000 + 2Q
Sample Problem:
Requirements:
Giant Screen TV, Inc. is a San Diego-based
importer and distributor of 60 inch screen, 1. Calculate output, Marginal Cost, Average Cost,
high resolution TV for individual and Price and Profit at the Profit –maximizing output
level.
commercial customers. Revenue and cost
relations are as follows: 2. Calculate output, Marginal Cost, Average Cost,
Price and Profit at the Average Cost –minimizing
TR = $1,800Q – $0. 006Q2 output level.
TC = $12,100,000 + $800Q + $ 0.004Q2 3. Calculate output, Marginal Cost, Average Cost,
Price and Profit at the Short-run Revenue–
MR = $ 1,800 - $ 0.012Q
maximizing output level.
MC = $ 800 + $0.008Q 4. Summarize your findings through a chart or table.
Compare and discuss your answer for 1 and 2.
Solution for Requirement No. 1
Solving for Output Quantity @ MR = MC Solving for Marginal Cost
1800 -0.012Q = 800 + 0.008Q MC = $ 800 + $0.008Q
1800 – 800 = 0.008Q + 0.012Q MC = 800 + 0.008 (50000)
1000 = 0.02Q MC = 800 + 400
1000/0.02 = Q MC = 1200
50000 = Q
Solution for Requirement No. 1
Solving for Average Cost Solving for the Price
AC = Total Cost/Quantity = TC/Q Price = Total Revenue/Quantity = TR/Q
TC = $12,100,000 + $800Q + $ 0.004Q2 TR = $1,800Q – $0. 006Q2
TC = 12,100,000 + 800(50000) + 0.004(50000)2 TR = 1800(50000) – 0.006(50000)2
TC = 12,100,000 + 40,000,000 + 10,000,000 TR = 90,000,000 – 15,000,000
TC = 62,100,000 TR = 75,000,000
AC = 62,100,000/50000 Price = 75,000,000/50,000
AC = 1242 Price = 1500
Solution for Requirement No. 1
Solving for Profit
Profit = Total Revenue – Total Cost =
TR – TC
Total Revenue = 75,000,000
Total Cost = 62,100,000
Profit = 75,000,000 – 62,100,000
Profit = 12, 900,000
Solution for Requirement No. 2
Solving for Output Quantity @ MC = TC/Q Solving for Marginal Cost
800 + 0.008Q = (12100000 + 800Q + 0.004Q2)/ Q
MC = $ 800 + $0.008Q
800 + 0.008Q = 12100000/Q + 800 +0.004Q
MC = 800 + 0.008 (55000)
800 – 800 = 12100000/Q – 0.008Q +0.004Q
MC = 800 + 440
0 = 12100000/Q – 0.004Q

0.004Q = 12100000/Q MC = 1240

0.004Q2 = 12100000

Q2 = 12100000/0.004

Q = √3025000000 (square root)

Q = 55000
Solution for Requirement No. 2
Solving for Average Cost Solving for the Price
AC = Total Cost/Quantity = TC/Q Price = Total Revenue/Quantity = TR/Q
TC = $12,100,000 + $800Q + $ 0.004Q2 TR = $1,800Q – $0. 006Q2
TC = 12,100,000 + 800(55000) + 0.004(55000)2 TR = 1800(55000) – 0.006(55000)2
TC = 12,100,000 + 44,000,000 + 12,100,000 TR = 99,000,000 – 18,150,000
TC = 68,200,000 TR = 80,850,000
AC = 68,200,000/55000 Price = 80,850,000/55,000
AC = 1240 Price = 1470
Solution for Requirement No. 2
Solving for Profit
Profit = Total Revenue – Total Cost =
TR – TC
Total Revenue = 80,850,000
Total Cost = 68,200,000
Profit = 80,850,000 – 68,200,000
Profit = 12, 650,000
Solution for Requirement No. 3
Solving for Output Quantity @ Maximum Solving for Marginal Cost
Revenue

MR = 0
MC = $ 800 + $0.008Q
MR = $ 1,800 - $ 0.012Q MC = 800 + 0.008 (150000)
1800 - 0.012Q = 0 MC = 800 + 1200
- 0.012Q = - 1800
MC = 2000
Q = -1800/-0.012

Q = 150,000
Solution for Requirement No. 3
Solving for Average Cost Solving for the Price
AC = Total Cost/Quantity = TC/Q Price = Total Revenue/Quantity = TR/Q
TC = $12,100,000 + $800Q + $ 0.004Q2 TR = $1,800Q – $0. 006Q2
TC = 12,100,000 + 800(150000) + 0.004(150000)2 TR = 1800(150000) – 0.006(150000)2
TC = 12,100,000 + 120,000,000 + 90,000,000 TR = 270,000,000 – 135,000,000
TC = 222,100,000 TR = 135,000,000
AC = 222,100,000/150000 Price = 135,000,000/150,000
AC = 1480.67 Price = 900
Solution for Requirement No. 3
Solving for Profit
Profit = Total Revenue – Total Cost =
TR – TC
Total Revenue = 135,000,000
Total Cost = 222,100,000
Profit = 135,000,000 – 222,100,000
Profit (Loss) = - 87,100,000
Solution for Requirement No. 4

Output Marginal Cost Average CostPrice Profit

Maximizing Profit 50000 1200 1242 1500 12900000
Minimizing Cost 55000 1240 1240 1470 12650000

To minimize Cost is not worth it as the savings gained is only $ 2.00

To maximize Profit is more beneficial as the additional profit amounts to $ 250,000
(12,900,000 - 12,650,000) from minimizing cost.
Exercise L5D8
Desktop Publishing Software, Inc. develops and markets Requirements:
software packages for business computers. Although sales
have grown rapidly during recent years, the company’s 1. Calculate monthly quantity, price, total
management fears that a recent onslaught of new revenue, total cost and Profit at the short-run
competitors may severely retard future growth Profit –maximizing output level.
opportunities. Therefore, it believes that the time has 2. Calculate monthly quantity, price, total
come to “get big or get out”. The marketing and revenue, total cost and Profit at the short-run
accounting departments have provided management with Average Cost –minimizing output level.
the following monthly demand and cost information:
3. Calculate monthly quantity, price, total
P = $ 1000 - $ 1Q revenue, total cost and Profit at the Short-run
Revenue–maximizing output level.
TC = $ 50000 + $ 100Q
4. Summarize your findings through a chart or
MR = $ 1000 - $2Q
table. Compare and discuss your answer for 1
MC = $100 and 2.
References:
Books:
1. Cruz, Milagros A., (n.d.) A Study Guide: Microeconomics, Self publication.
2. Cruz, Milagros A. (2017) Business Economics, Anvil Publishing, Inc.
Mandaluyong City, Philippines. ISBN 978-971-27-3325-3
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